Inditex: A Slowing Economy Is Bad, Unless You Are Zara (OTCMKTS:IDEXF)

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A slowdown in the economy indicates layoffs, which in turn indicates that people are on their best behavior during interviews. When someone is stacked against 20 other candidates for a position, they have very good reason to win one noticeable edge, which makes buying an affordable fast fashion piece a very appealing option. This is one of the reasons why investors Industria de Diseño Textil, SA (OTCPK:IDEXY, OTCPK:IDEXF) – commonly referred to as Inditex – as the company is expected to grow even larger due to the current economic changes.

Inditex seems poised to benefit from a slowdown given the mid-to-bottom price structure of its commodities. As people’s earning power is squeezed by rising interest rates, they tend to lower their shopping preferences, giving the company an opportunity to gain more market share.

I think Inditex is undervalued and a good option for investors looking to enter a consumer staples portfolio with a market-leading large-cap company. The stock strikes a balance between long-term growth and a dividend yield of around 4.15%. In my valuation, I valued the company and its Zara brand at €85.6 billion, or €27.5 per share, a discount of 20%.

Zara’s more than 6,000 stores, brand awareness and global presence will allow the company to continue to grow and become a leader in the sector.

Zara’s defensive attributes: The FOMO Cycle and Inflation collection

A big part of the appeal of fast fashion retailers is the therapeutic aspect of bargain hunting. Inditex positions itself as a mid-to-low-priced retailer, allowing people to dress similarly to higher-end brands while maintaining a sense of bargain hunting.

The company has a five-week cycle from design to retail and ships more than 20 collections annually. This rotation between stores (mostly at Zara) keeps the collections fresh and creates a feeling of “FOMO” among customers, knowing that if they find a good piece, it won’t be there next week becomes. Inditex continued to push the FOMO card, opting to pass the cost of inflation on to consumers rather than absorbing the shocks. For customers who anticipate further inflation in the coming months, this gives an added incentive to buy goods now even though prices have risen – as they have to anticipate additional inflation in the future.

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Inditex segments and Geo

Inditex has a rich brand portfolio consisting of its flagship brand Zara – a trend retailer – and five other differentiations. Here’s how their brands are approaching the market compared to Zara:

  • Pull&Bear – Leisure & Sport

  • Massimo Dutti – Relatively high quality business attire

  • Bershka – Relatively low end, latest fashion

  • Stradivarius – urban & casual for women

  • Oysho – sports, lingerie, nightwear for women.

The table below shows the performance of each brand in the first six months of 2022:

Distribution of sales of Inditex by brand

Chart 1. Inditex Sales Distribution by Brands (Company Presentation)

We can see that overall sales are up 24.5% year over year, with Zara leading the rise and accounting for 74% of sales.

It is important for investors to note that a diversified product portfolio helps reduce risk by testing and establishing different branding strategies. It also allows the company to conquer different market segments.

Inditex is a global retailer with 6,477 stores, representing 4.7 million square meters at the end of 2021. The company is committed to optimizing existing locations and driving growth through digital channels, where it expects online sales to exceed 30% of total sales by 2024 (1, 2).

Inditex revenue by geography

Chart 2. Inditex Sales by Geography (Company Presentation)

Next we will examine the fundamentals and see what this means for the valuation of the company.

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Financial performance and evaluation

I valued Inditex at 85.6 billion euros, or 27.5 euros per share. This gives us a 1-year price target of €28.7, which translates to around 31% upside potential.

The graphic below shows the model used to arrive at our rating. You can also view and edit the full model to include your vision of the business.

Inditex's financial history and future estimation model

Diagram 3. Inditex financial history and future estimation model (image created by the author with data from FMP)

To create the above model, we had to make some assumptions about the future of the company:

growth

Inditex has managed to get back on track for growth, recovering to €30.6 billion in sales over the past 12 months. As the company manages to pass on the cost of inflation, we can reasonably expect nominal sales growth to continue at a steady pace.

Inditex sales growth on a TTM basis

Chart 4. Inditex sales growth based on TTM (image created by the author with data from FMP)

profitability

I focus on the company’s free cash flow as a measure of its bottom line. For Inditex, the company appears to be doing a good job of cash conversion, and free cash flows often outpace EBIT. This is due to good working capital management and a negative net CapEx that writes off more than it invests.

Currently, the company has an EBIT margin of 16.4% and a slightly higher FCFF margin of 19.4%.

Inditex TTM profitability margins

Chart 5. Inditex TTM profitability margins (image created by the author with data from FMP)

While historical EBIT margins have been below 20%, we may be able to make a case for higher future margins due to the higher profitability of the online distribution business and future optimization strategies.

risks

I rate the company as 10% less risky than the market portfolio given its defensive product line, diversified product portfolio, debt at 7% to market value of capital, and risk associated with the apparel industry. However, we must keep an eye on future developments and see two main potential risks that may impact the business.

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Marketplace Apps

The rise of marketplace apps like Facebook’s marketplace (META), Pinterest (PINS), Etsy (ETSY), and merchant enablers like Shopify (SHOP) and Amazon (AMZN) are transferring market share from centralized retailers to smaller and local sellers. While large retailers like Inditex are trendsetters and have integrated efficient production chains into their business, the increased availability can limit sales growth and reduce the potential for profitability margins. Fast fashion also means easy to make, which is great for marketplace arbitragers as they can buy clothes from white label suppliers and sell them locally at comparable quality.

Circular fashion trends

A report by ThredUp (TDUP) estimates that the US used goods market will grow to $82 billion in 2021 from $35 billion in 2021, largely driven by resale activity. While fast fashion retailers like Zara are seen as safer from this trend, investors should consider the increasing availability of second-hand solutions. As we mentioned at the beginning, shopping is part of therapy, and finding bargains can be replaced with spending responsibly.

If management thinks this is going to be a significant factor, they can try to offset it by adopting their own branded version of the approach. However, history shows that older companies tend to be too slow to respond to disruptive trends and sometimes end up losing market share permanently.

Possible investment approach

While I reckon the stock is undervalued and in a good position to continue growing, it could be a good strategy to consider Inditex in a bundle with some peers or disruptors. These companies are beyond the scope of this analysis, but I would consider companies like SHOP, ETSY, PINS, and META to explore their market potential in more detail.

That said, investors should expect about 50% of the return to come as dividends and half as stock appreciation from increased free cash flow. The stock seems like a good option for balanced and income investors given its 4.15% dividend yield.

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